4 Types of Stock Market Investment Strategies (Part 2)

· Financial Services

3. Trading

Advances in technology, lower commission rates, and the appearance of online brokerage firms have enabled individuals to employ tools and systems of increasing sophistication to follow and interpret the market. Individuals and Wall Street firms alike have embraced a new trading philosophy, with many employing artificial intelligence programs and complex algorithms to buy and sell huge stock positions in microseconds.

A trader is someone who buys and sells securities within a short time period, often holding a position less than a single trading day. Effectively, he or she is a speculator on steroids, constantly looking for price volatility that will enable a quick profit and the ability to move on to the next opportunity. Unlike a speculator who attempts to forecast future prices, traders focus on existing trends – with the aim of making a small profit before the trend ends. Speculators go to the train depot and board trains before they embark; traders rush down the concourse looking for a train that is moving – the faster, the better – and hop on, hoping for a good ride.

The bulk of trading occurs through financial institutions’ programmed systems to analyze price trends and place orders. Emotion is removed from the buy-sell decision; trades are automatically entered if and when a specific criterion is reached. Sometimes referred to as “algorithmic or high-frequency trading (HFT),” the returns can be extraordinarily high. A 2016 academic study of HFTs revealed that fixed costs of HFT firms are inelastic, so firms that trade more frequently make more profits than firms with fewer transactions with trading returns ranging from 59.9% to almost 377%.

The impact of high-frequency trading and the firms engaged in the activity remains controversial – a 2014 Congressional Research Service report detailed instances of price manipulation and illegal trading methods such as detailed in Michael Lewis’ book “Flash Boys.” There are also concerns that automated trading reduces market liquidity and exacerbates major market disruptions, such as the May 6, 2010, market crash and recovery – the Dow Jones Industrial Average dropped 998.5 points (9%) in 36 minutes. A similar crash happened August 24, 2015 when the Dow fell more than 1000 points at the market open. Trading was halted more than 1,200 times during the day in an effort to calm down the markets.

While few individuals have the financial ability to emulate the trading habits of the big institutions, day trading has become a popular strategy in the stock market. According to a California Western Law Review report, day trading continues to attract adherents, even though 99% of day traders are believed to eventually run out of money and quit. Many become day traders due to the enticement of day trading training firms, an unregulated industry that profits from the sale of instruction and automated trading software to their customers. The sales materials imply that the software is similar to the sophisticated, expensive software programs of the big traders, such as Goldman Sachs.

Day trading is not easy, nor for everyone. According to Chad Miller, managing partner of Maverick Trading, “Everyone glorifies it [day trading], but its hard work…you can’t just turn on the computer and buy a stock and hope you make money.” Day trading generally involves tens of trades each day, hoping for small profits per trade, and the use of margin – borrowed money – from the brokerage firm. In addition, margin traders who buy and sell a particular security four or more times a day in a five-day period are characterized as “pattern day traders,” and subject to special margin rules with a required equity balance of at least $25,000.

Despite the number of new day traders entering the market each year, many securities firms and advisors openly discourage the strategy. The Motley Fool claims that “day trading isn’t just like gambling; it’s like gambling with the deck stacked against you and the house skimming a good chunk of any profits right off the top.”

4. Bogeling (Index Fund Investing) – A New Philosophy

Frustrated by inconsistent returns and the time requirements to effectively implement a fundamentalist or speculator strategy, many securities buyers turned to professional portfolio management through mutual funds. According to the Investment Company Institute’s Profile of Mutual Fund Shareholders, 2015, almost 91 million individuals owned one or more mutual funds by mid-2015, representing one-fifth of households’ financial assets. Unfortunately, the Institute learned that few fund managers can consistently beat the market over extended periods of time. According to The New York Times, “The truth is that very few professional investors have actually managed to outperform the rising market over those years [2010-2015].”

Influenced by the studies of Fama and Samuelson, John Bogle, a former chairman of Wellington Management Group, founded the Vanguard Group and created the first passively managed index fund in 1975. Now known as the Vanguard 500 Index Fund Investor Shares with a minimum investment of $3,000, it is the precursor of many similar index funds managed by Vanguard – including the largest index mutual fund in the world, the Vanguard 500 Index Fund Admiral Shares, with assets of $146.3 billion and a minimum investment requirement of $10,000.

Despite the industry skeptics about index investing, Bogle’s faith in index investing was unshaken. The following statements express his views, and are the basis of his book, “The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns.”

Investors as a group cannot outperform the market because they are the market.

Investors as a group must under-perform the market, because the costs of participation – largely operating expenses, advisory fees, and portfolio transaction costs – constitute a direct deduction from the market’s return.

Most professional managers fail to outpace appropriate market indexes, and those who do so rarely repeat in the future their success in the past.

The fund was initially ridiculed as “Bogle’s Folly” by many, including Forbes in a May 1975 article entitled “A Plague on Both Houses.” (The magazine officially retracted the article by Forbes writer William Baldwin in an August 26, 2010 article.) The Chairman of Fidelity Investments, Edward C. Johnson III, doubted the success of the new index fund, saying, “I can’t believe that the great masses of investors are [sic] going to be satisfied with just average returns. The name of the game is to be the best.” Fidelity subsequently offered its first index fund – the Spartan 500 Index Fund – in 1988 and offers more than 35 index funds today.

With the success of index mutual funds, it is not surprising that exchange traded funds (ETFs) emerged 18 years later with the issue of the S&P 500 Depository Receipt (called the “spider” for short). Similar to the passive index funds, ETFs track various security and commodity indexes, but trade on an exchange like a common stock. At the end of 2014, the ICI reported that there were 382 index funds with total assets of $2.1 trillion.

Multiple studies have confirmed Bogle’s assertion that beating the market is virtually impossible. Dr. Russell Wermers, a finance professor at the University of Maryland and a coauthor of “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimating Alphas,” claimed in an article in The New York Times that the number of funds that have beaten the market over their entire histories is so small that the few who did were “just lucky.” He believes that trying to pick a fund that would outperform the market is “almost hopeless.”

Some of America’s greatest investors agree:

Warren Buffett. The Sage of Omaha, in his 1996 Berkshire Hathaway shareholder letter, wrote, “Most institutional and individual investors will find the best way to own common stock is through an index fund that charges minimal fees.”

Peter Lynch. Described as a “legend” by financial media for his performance while running the Magellan Fund at Fidelity Investments between 1977 and 1980, Lynch advised in a Barron’s April 2, 1990 article that “most investors would be better off in an index fund.”

Charles Schwab. The founder of one of the world’s largest discount brokers, Schwab recommends that investors should “buy index funds. It might not seem like much action, but it’s the smartest thing to do.”

Adherents to index investing are sometimes referred to as “Bogel-heads.” The concept of buying index funds or ETFs rather than individual securities often includes asset allocation – a strategy to reduce risk in a portfolio. Owning a variety of asset classes and periodically re-balancing the portfolio to restore the initial allocation between classes reduces overall volatility and ensures a regular harvesting of portfolio gains.

In recent years, a new type of professional management capitalizing on these principals – robo-advisors – has become popular. The new advisors suggest portfolio investments and proportions of each allocated in ETFs based upon the client’s age and objectives. Portfolios are automatically monitored and re-balanced for fees substantially lower than traditional investment managers.

Final Word

Stock market profits can be elusive, especially in the short term. As a consequence, those seeking to maximize their returns without incurring undue risk constantly search for the perfect strategy to guide their activity. Thus far, no one has discovered or developed an investment philosophy or strategy that is valid 100% of the time. Investment gurus come and go, praised for their acumen until the inevitable happens and they join the roster of previously humbled experts. Nevertheless, the search for a perfect investment philosophy will continue.

As a participant in the securities market, you should recognize that owning securities can be stressful. Just as you do not know the events of tomorrow and how investors will react to news and rumors, so you do not have the certainty of profits in the stock market. So enjoy those days when fortune and goals come together, but remember and prepare for the times of disappointment, for they will be many.

What guides your decisions to buy and sell securities? Have you had success with one of the philosophies above?